Required minimum distributions, or “RMDs,” are a tax law that every retiree needs to understand.

Specifically, under the RMD law you can’t just leave your money in place indefinitely. You need to start taking withdrawals from qualifying pre-tax retirement accounts starting at age 73, and you need to pay taxes on that money. So it’s important to make a plan for how you will manage all of this. Among other issues, you should make sure to plan for tax payments, asset balancing and managing the money you’ve withdrawn.

For example, let’s say that you’re 76 years old with $460,000 in a 401(k) account. How should you handle the required minimum distributions on this account? Here are a few things to think about. And for personalized guidance, consider using this free tool to match with up to three fiduciary financial advisors.

How to Take Your RMDs

The first thing to remember about required minimum distributions is that they are, as the name suggests, required. In our example here, you are 76 years old, which means this isn’t your first year taking RMDs.

If you have not been taking your RMDs already, you will owe a tax penalty worth 25% of the amount you did not withdraw. For example, say you had a $10,000 RMD last year and only withdrew $4,000 from your 401(k). You would owe a tax penalty of $1,500 ($10,000 required – $4,000 taken = $6,000 under-withdrawal * 0.25 penalty).

You can reduce this tax penalty to 10% if you correct the mistake within 2 years. In this case you should use Form 5329 to notify the IRS that you have withdrawn the required amount. You can also use Form 5329 appeal for a waiver of all penalties, which the IRS can grant at its discretion if you demonstrate that your under-withdrawal was the result of mistake, good-faith error, or circumstances outside your control.

Beyond that, you can structure your RMD withdrawals at your discretion. You must have the full amount withdrawn by December 31 of the year in question. During the year, however, you can take these withdrawals in any amount, at any time. Depending on how your portfolio is structured, you may not even have to sell assets if you can simply transfer your securities out of the pre-tax portfolio and into a taxed account. A financial advisor can help you determine your RMD amount and develop an appropriate strategy based on your goals. The rules are nuanced and may vary depending your age.

Plan for Your Taxes

Here, you’re 76 with $460,000 in your 401(k). This means you will need to withdraw approximately $19,409 by the end of the year. The next thing on your radar should be taxes.

The entire point of required minimum distributions is to trigger income taxes. This rule applies to pre-tax portfolios, meaning that it’s all money on which you haven’t been taxed, so the IRS wants to make sure this happens eventually. For example, this year you will owe at least $556 on this withdrawal. That doesn’t account for any other taxes you owe due to additional income from other sources, it is simply the minimum amount you would owe on this withdrawal.

One of the most important parts of handling your RMDs, then, is making sure you plan to pay those taxes. This means either setting aside money from your withdrawal or keeping cash on hand from other sources. Either way, you need to be ready to pay your tax bill.

One way to reduce RMD-related taxes for distributions your don’t need is through what is called a Qualified Charitable Donation (QCD). Like many tax strategies, this is a little tricky. With a QCD, you make a direct donation from your retirement account to a qualifying charity. This withdrawal counts toward your minimum distribution and, since it is a charitable donation, you will not owe any taxes on it. This lets you meet your RMDs without triggering income taxes.

However, in all but a few edge cases, you do end up losing money off this transaction. With a QCD, you give 100% of the money you have donated. With income taxes, you lose a percentage of the money you withdraw. Paying 20% of your withdrawal to income taxes still leaves you with 80% of your money, which is 80 percentage points more you keep with a QCD.

This isn’t to say that qualified charitable donations are bad things. In particular, they are fantastic ways to maximize the tax benefits of charitable giving in retirement. If you already want to make a donation, a QCD can be a great way to give money and save on taxes. However, if you want to maximize your personal finances, run the numbers and make sure you actually come out ahead here.

If a QCD is the right plan for you, you will need to make an IRA rollover. You cannot make a qualified charitable distribution directly from a 401(k). Instead, first you must move the money to an IRA, then you can make the donation. Consider speaking with a financial advisor to weigh your options.

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Plan for Asset Balancing and Optimization

You may want to avoid just taking your withdrawals at random.

In almost all cases, taking withdrawals from your 401(k) or other retirement portfolios will mean selling your assets and transferring the cash to a bank account. Which assets you sell and when matters.

With a pre-tax retirement account like a 401(k), you don’t have to worry about the same tax harvesting strategies you would use with a taxed portfolio. Since you pay taxes on both principal and returns, it’s less important to structure your sales around duration and growth of any particular holding. That said, you do want to carefully consider the investment position and strategy of each asset before you sell it.

For example, when you take an RMD, try to focus on assets whose value may have peaked, or that you’ve held for a long time. Long-term investments have had more time to grow, meaning that you’ve collected more returns from those assets relative to investments you made more recently. If you have assets that just aren’t performing and aren’t likely to, your RMDs might be a good time to unload those underperforming investments while leaving strong assets in place. If you have income-generating assets, you might want to leave those alone in favor of selling capital assets.

These are all examples of how you might want to optimize your withdrawals. The core point is to make sure you sell assets and take distributions based on your financial plan. Think about what assets you will sell to make sure your portfolio still reflects your long-term investment strategy, and to make sure that it is risk-balanced appropriately.

Defer, Delay or Eliminate RMDs

Finally, there are a handful of ways you can defer or eliminate your RMD requirements.

At 76, one of the best options to consider is what’s called a Qualified Longevity Annuity Contract (QLAC). These is a form of lifetime annuity that you can purchase with pre-tax portfolio money. As with all annuities that you buy with pre-tax assets, you will have to pay income taxes on the payments you receive from this annuity.

However, when you purchase this contract you can specify when you want the payments to begin. You can delay collections until as late as age 85, and this contract will entirely satisfy your RMD requirements. While the annuity is pending (that is, while you are not collecting payments) the IRS will not require you to take minimum distributions on the amount you invested in the QLAC. Once the annuity begins to make payments, those payments will fulfill your RMD requirements.

In practice, then, this allows to you defer RMD requirements as late as age 85. At age 76, this can be an excellent way to put off any future RMD obligations.

You can also eliminate your RMD requirements altogether with a Roth IRA conversion. A Roth conversion is when you move money from a qualifying pre-tax portfolio, like a 401(k), into a Roth IRA. Once you do this, you will no longer have to take minimum distributions from this portfolio, since RMD rules do not apply to Roth IRAs.

The catch is that you must pay income taxes in full on the amount that you convert in the year that you make the conversion. In retirement, with significant savings, this can mean paying a very large tax bill in order to avoid future smaller tax payments. For example, here, if you moved all $460,000 in one year you might owe at least $128,000 in conversion taxes. This can a significant bite out of your savings, so make sure that you have a long-term plan for this transfer.

A financial advisor can help you navigate RMDs, the associated taxes and other elements of retirement. Get matched today.

The Bottom Line

In your mid-70s, required minimum distributions are a real issue. These withdrawals begin at age 73, so make sure you have begun to plan for how you will take out this money, how you will pay the resulting taxes, and how you will plan your portfolio around the withdrawals.

Planning for RMDS

When it comes to planning for your RMDs, the place to start is with the calculations. What, exactly, do you have to take out in the first place? Once you know that, you can decide how you want to manage this annual requirement.
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